Tuesday, July 5, 2016

Erik Reinert versus Ricardo on Free Trade

What follows is based on Erik S. Reinert’s book How Rich Countries Got Rich, and Why Poor Countries Stay Poor (2007), pp. 301–304.

Ricardo’s famous example of cloth and wine production in Portugal and England (Ricardo 1819: 144–148) can be set out in the following table:

Ricardo’s argument is simple: Portugal can produce more wine by concentrating on the production of that, and import cloth from England, even if (as in Ricardo’s example) it takes fewer labourers to produce cloth in Portugal than in England. The aggregate effect of England concentrating on producing cloth (where its comparative advantage lies owing to the lower opportunity cost) and Portugal producing wine is that a greater quantity of these commodities can be produced in total, and Portugal and England can exchange them to mutual benefit, instead of producing fewer goods in isolation and autarky.

It is better, according to Ricardo, that each nation should specialise in the sector where it has comparative advantage, and then trade.

But this is not necessarily true, once we relax the grossly unrealistic assumptions implicit in Ricardo’s thought experiment.

For one thing, Ricardo has assumed that there are neither increasing nor diminishing returns to scale.

If Portugal concentrates on wine production (or indeed on any sector of the same type), it will get caught in a trap of diminishing returns and rising costs of production, and in the end will specialise in becoming poor as it fails to industrialise (Reinert 2007: 302).

And now we have a killer point that Erik Reinert makes against Ricardo’s argument:

“It is important to understand that … [sc. Ricardo’s] theory represents the world economy as a process of bartering of labour hours which are devoid of any skills or other characteristics. A labour hour in Silicon Valley equals a labour hour in a refugee camp in Darfur in the Sudan. Ironically, capitalist trade theory in its purest form does not consider the role of capital; instead it is based on the labour theory of value. Therefore it does not consider that one country’s production process might potentially absorb much knowledge and capital (like Microsoft's products) while the other country’s production process might remain highly labour-intensive, in processes where capital cannot profitably be employed … .” (Reinert 2007: 303).

Remember that Ricardo was not a marginalist, but a Classical economist using the pre-Marxist labour theory of value.

Reinert has put his finger on a devastating point here: one of Ricardo’s crucial arguments in favour of free trade by comparative advantage is based on the idea that specialising in the production of some commodity is inherently better just because of the comparatively lower labour time involved in production. As Robinson pointed out:

“Ricardo’s analysis of comparative advantage is often misunderstood. The comparison is not between the costs of production, in money terms, of particular commodities at home and abroad; it is a comparison between the real costs (in terms of labour and other resources) of different commodities at home. The argument was that, when protection is taken off, resources will move from the production of commodities with high real costs (which can then be imported) to those with lower real costs so that their productivity is increased.” (Robinson 1979: 102–103).

That this is a good thing, as Ricardo thought, doesn’t follow at all.

Even if it takes more labour hours and human labourers to produce manufactured goods, in the long run this is a key to becoming rich, whereas dead-end production of commodities with diminishing returns to scale, even if it requires fewer labour hours and labourers, is a path to Third World poverty.

Reinert (2007: 302–304) goes on to construct an example in which, under Ricardo’s principle of comparative advantage, Portugal should specialise in producing Stone age goods, while England specialises in industrial goods: the result is that the world economy might be better off by a larger, total number of goods, but the price is that Portugal must remain in the Stone age.

In essence, Ricardo’s argument ignores the long-run benefits of industrialisation, which is the only real way to escape the grinding rural poverty of underdevelopment – unless of course you are lucky enough to be one of the minority of nations that has lucrative commodities like energy, or to be some tiny city-state that can get by on service industries. In the long run, Portugal is better off producing cloth and other manufactured goods, not just wine.

Moreover, as Philip Pilkington points out here, violent swings in the demand for, and prices of, the primary commodities in which Third World nations are often supposed to have comparative advantage will cripple and destabilise these developing nations when their economies are so narrowly specialised in limited sectors.

The fact that Ricardo wrote before the full effects of the industrial revolution were apparent should alert us to the deficiencies of his argument too.

even before my post keynesian period when i just started to be interested in economics (i was hardcore mercantalist by nature back then) when i argued with neoclassical economists about free trade they showed me ricardos comparative advantage equation and the first thing i told them well its all depends not on hours worked but on which product is more desireable (which product is more demanded) they laughed at me and told me i dont understand anything about economics.

but when i read in your blog that not only marx supported the labour theory of labour but ricardo as well i found out that i was actually right and i am not the one in this arguement which cant understand mainstream economics is the mainstream economists by themself who use labour theory of value arguements while they are marganlists.

This is rather Erik Reinert versus the so-called Ricardian trade model – not Ricardo. The trade model was developed by later economists based on some fundamental misunderstandings of the original numerical example in the Principles. In case you are interesting in finding out what Ricardo actually wrote, and how it differs from the textbook trade model of comparative advantage, please read here: http://etdiscussion.worldeconomicsassociation.org/?wea_paper=ricardos-numerical-example-versus-ricardian-trade-model-a-comparison-of-two-distinct-notions-of-comparative-advantage

Dear Daniel and whoever wrote the second comment, You are of course entitled to use your time as you please. There are surely better ways to spend an afternoon than reading my paper, but since you seemed to care about the topic, I thought you would be interested in finding out what Ricardo actually wrote. It is not very complicated. Ricardo meant to prove two propositions with the numerical example: 1) “the same rule which regulates the relative value of commodities in one country, does not regulate the relative value of the commodities exchanged between two or more countries” (Principles, p. 133), which means that “the quantity of wine that she [Portugal] shall give in exchange for the cloth of England, is not determined by the respective quantities devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal” (pp. 134-135). Thus, his labor theory of value is not valid in international exchanges.

2) that a country might import a certain quantity of a commodity although it could produce it internally with less amount of labour time than the exporting country, and that such an exchange would be beneficial for both trading partners.

Both propositions are still valid today, as anyone can find out empirically. So whatever you have read about comparative advantage, including the term itself, is not from Ricardo.

i can speak about how cheaper imports may be not really cheaper since nobody said that subsititution effect will be stronger than income effect and in turn on salaries unless there is benevelonet central authority (interesting assumptions for neoclassical economists i think) which cares to distribute the income earned by your country and spread it between people in a manner that everyone will get the same marginal utilitiy from 1 more dollar which of course is ridicouls unless you are saying that bill gates happy as much as homeless man from another dollar he earn or get (gorman 1953,sameulson 1956)https://en.wikipedia.org/wiki/Sonnenschein%E2%80%93Mantel%E2%80%93Debreu_theorem

2.i can speak about how returns to scale are important and how elasticity of demand for your production compare to the other is important as well (since its easy to do this analyze by a country (since it can be cheaper for you to produce your products in terms of his products but because its less demanded by his the other country people and their products more demanded by yours it will create continious trade deficit).

https://en.wikipedia.org/wiki/Thirlwall%27s_Law

https://en.wikipedia.org/wiki/Prebisch%E2%80%93Singer_hypothesis

empirical evidence for this hypothesis

https://www.imf.org/external/pubs/ft/wp/2013/wp13180.pdf

i can speak about empirical evidence for protectionism in work you are welcome to look at the development of china taiwan japan south korea and even the hardcore interventionist singapore,also you can look at usa during 18-19 centuary and germany even chile really started to grow economically after its introduced keynseian policies and trade subisidies and tarrifs on strategic industries.

you can look at mexico before the neoliberal age when IMF imposed on it to be more of a free trader.

also jorge i can challenge you by this questionCan you give examples of countries that prospered under unrestricted free trade policies, without being unusual, very small countries with lucrative service sectors (e.g., maybe Hong Kong), or (2) countries with some huge gift of high-value natural resources like energy, e.g., Saudi Arabia?

now i have to continue this in another comment since i cant post it here

In one and the same country, profits are, generally speaking, always on the same level; or differ only as the employment of capital may be more or less secure and agreeable. It is not so between different countries. If the profits of capital employed in Yorkshire, should exceed those of capital employed in London, capital would speedily move from London to Yorkshire, and an equality of profits would be effected; but if in consequence of the diminished rate of production in the lands of England, from the increase of capital and population, wages should rise, and profits fall, it would not follow that capital and population would necessarily move from England to Holland, or Spain, or Russia, where profits might be higher.It would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances, the wine and the cloth should both be made in Portugal, and therefore that the capital and labour of England employed in making cloth, should be removed to Portugal for that purpose. In that case, the relative value of these commodities would be regulated by the same principle, as if one were the produce of Yorkshire, and the other of London: and in every other case, if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold.

Experience however shews, that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connexions, and intrust himself with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.

ricardo here clearly saying that if capital owners will move easily between countries and will move capital easily between countries absoloute advantage taking the place of comparative so ricardian comparative advantage is not working anyway in our world of today thats why we have a race to the bottom.

Dear Daniel, Thank you for bringing the direct quote and letting Ricardo speak for himself. The problem is in the interpretation of the quote. Ricardo is not saying anything about absolute or comparative advantage there. He is offering an explanation for why the labor theory of value is not valid in international exchanges. According to him, it is because capital is less mobile between countries borders than within the same country. Just read again the paragraph "It would undoubtedly...to be sold. The classical case for free trade is not based on Ricardo's numerical example. It is the neoclassical case which is based on a concept of comparative advantage that has nothing to do with Ricardo.

I will link to your paper soon in a new post on my blog (probably tomorrow).

However, at Lars P. Syll’s blog, you have said the following:

“Furthermore, for Ricardo the relevant cost comparison for specialization is between the amounts of labor time necessary to produce the amounts of commodities traded in the same country. It is an internal cost comparison.”https://larspsyll.wordpress.com/2013/09/27/ricardos-theory-of-comparative-advantage-is-not-relevant-anymore/#comment-6877

But this is not a new interpretation. Joan Robinson in Aspects of Development and Underdevelopment (1979), pp. 102–103, as you can see for yourself above, said the same thing. I am also saying the same thing above.

But, as I also said above, such an argument for comparative advantage based on labour time is a grossly inadequate and flawed argument for unrestricted free trade, because it ignores the fact that manufacturing, in the long run, has increasing returns to scale and makes your nation wealthier, whereas other non-industrial sectors with diminishing returns to scale and rising costs of production lead to a dead-end poverty trap.

dear jorge,if ricardo case is for absoloute advantage is have the same problem as with smith that when capital moving easily between countries it will go to the cheapest place available and will benefit maybe the capital owner at the expense of labour and the country exactly the reason why its not a case for free trade (the only excuse of adam smith that it will work anyway is because of national pride capital owners will still stay in britan not really good arguement indeed).

now as you can see i wrote to you another comment above the one you answered in this comments i gave you theortical and empirical evidences (welcome to read the books of ha joon chang for empirical evidences and imf research about prebich singer hypothesis).

also i should note that full employment needed to sustain ricardo theory since without it you cant sustain equilibrium (which is when all the markets are clear simultaneously otherwise the mechanism of prices is misleading and can cause to mislocations of resources including of import and export decisions which in turn will create even further mislocation of resources unless the equlibria is stable and the economy is returning fast into equilibria .

but for equilibria to happen walras used the assumption of auctioner which will not sell anything until all the prices will clear all the markets labour market included (walras 1874).

but since walras times its been proven that its cannot happen (there is no set of prices which will clear all the markets in the same time) (by using leontief matrix).

https://en.wikipedia.org/wiki/Perron%E2%80%93Frobenius_theorem

https://en.wikipedia.org/wiki/Input%E2%80%93output_model

and that its actually unstable equilibria and there is no tendency to return to equilibria as well (blatt 1983) so in this case if there is no full employment you cant really know the real prices of anything since there is no real price until all markets are clear but they are never clear specially if there is no full employment and there is no equilibrium and as blatt showed using input output matrix of leontieff small changes from equilibrium can create great changes and it will not come back to equilibrium.

so pls add this arguement to the arguements i gave you above my comment which you commented on.

Dear L.K.,Thanks for taking the time to read my paper. I will consult Robinson's book in order to get a broader picture about her views on the topic. The issues we are discussing are rather complex and therefore not suited for this format, but I will try to be as concise as possible. It is not only an internal comparison of quantities of labor, but more importantly, a comparison which is based on a certain rate of exchange between commodities. Ricardo did not assume that the labor requirements nor the exchange rate between commodities would remain constant. Quite the opposite: they vary often daily. A country might find it advantageous to import cloth and pay with the exportation of wine today, but not tomorrow or the next month (year). The conclusion which scholars have extracted from the numerical example that Portugal should completely specialise in the production of wine and England in cloth, or by extension that one nation should specialise in industrial goods and the other in agricultural goods, is not what the original numerical example is all about. Furthermore, I don't think it is possible to make such a clear dichotomy between industrial and non-industrial sectors. The industrial method of production or manufacturing can be implemented in almost any sector of the economy. Today one can find industrial methods of production in agriculture, franchise restaurants and even travel packages. I think we can agree that free trade encourages rather than discourages the deployment of industrial methods of production.

(2) "I think we can agree that free trade encourages rather than discourages the deployment of industrial methods of production. "

No, I don't agree. You are wrong.

The modern argument for free trade encouraging Third World countries to overspecialise in primary commodities to obtain export-led growth, which are clearly subject to diminishing returns and wildly fluctuating swings in commodity prices keep many of them poor.

Dear Daniel, Please show me the country that has been able to produce everything more cheaply than others. I'm not aware that such a situation has ever occurred.I have read the empirical "evidence" presented by Chang and even Friedrich List, for that matter. The problem is that one cannot make an empirical case for or against free trade. Smith and Ricardo argued on a theoretical basis that free trade would increase wealth more rapidly than any protectionist trade policy. They did not argue that protection would impede economic development altogether.

Following LK: What would happen and above all, what did happen. What does it mean an "empirical case for or against it"? 500 years of history! Sometimes I think freetraders believe that without protectionism we would have discovered the technology to live in space without oxygen or something like that. Nobody is against free trade, neither List nor Chang, they say that it is a matter of time, of productive structure, of context and so on (exactly like protectionism).

Dear colleagues, I should explain the problem with the empirical evidence. Smith's and Ricardo's case for free trade was that this trade policy would increase the wealth of a country more rapidly than a policy of protection.For proving such a claim empirically, you would have to take two identical countries with one adhering to the principle of free trade and the second implementing some sort of protection. After some period of time, one would have to measure which of them was able to increase its wealth more rapidly. Obviously, this cannot be done. So what is the empirical evidence that Chang and List are referring to? That Britain, the US, France, you name it, used some kind of protection when they were "developing" countries. Nobody disputes this.Is this a sufficient empirical proof for affirming that every country needs protection for its economic development? I don't think so. Correlation does not imply causation. Almost every country mentioned by Chang and List was also quite belligerent during this period, engaging in frequent wars. Would you infer from this correlation that engaging in military conflicts is indispensable for economic development? Of course not. You all seem to be quite critical of the mainstream neoclassical case for free trade, with its unrealistic models and assumptions. I share your criticism, but I want to draw your attention to the fact that there is another case for free trade which is not based on these gadgets. In order to appreciate it, you would have to question what you have learned so far about Smith and Ricardo and reread the original sources with an open mind.

"Smith's and Ricardo's case for free trade was that this trade policy would increase the wealth of a country more rapidly than a policy of protection.

And we are not disputing that Ricardo's argument, under the conditions assumed, works. Even in the real world, the evidence would suggest that, yes, output would increase provided constant returns to scale and stable demand.

This is not the issue. The issue is: is it better for a nation to shun those industries where its comparative advantage lies when they are dead-end sectors that will have diminishing returns to scale and rising costs?

Is it better for many underdeveloped nations that have large enough internal markets and resources to impose infant protectionism and develop a manufacturing sector with the long-run advantages that this will bring? The answer is: yes.

Your only answer above, astonishingly, suggests you do not even think sectors with diminishing returns even exist, and that you think a nation without lucrative natural resources could become as rich by free trade as first world nations without industrialisation. If so, tell us which nations did this.

"So what is the empirical evidence that Chang and List are referring to? "

They are referring to the fact the evidence suggests that many later-starting nations were only able to industrialise by protectionism, given that their industries could not compete with established producers like England.

And even in England itself, in the late 18th and early 19th century the cotton textile industries only developed with strong protectionist measures to keep out cheap Indian calicoes:

I agree, Ricardo and Smith were very different from neoclassical economists. Smith for example approved some typical "mercantilis policies" such as the Navigation Act, he called it a wise policy. Even Ricardo knew that it was just a model, in a sense, they understand that economics was a social science. I didn't want to show disrespect to these scholars.

The problem in their model lies in the absence of economic complexity and qualitative difference among goods and services. Producing raw materials is different from producing a software or equipment for photo laboratories. They need different skills, different productive structure and organisation and they have different learning curves. LK mentions the dichotomy between increasing and decreasing returns, and that's probably the most important. But learning by doing is another. There is a huge difference between learning to design and produce complex goods such as those mentioned, and produce raw materials. Seriously, I'm not saying nothing new, it was common sense centuries ago, from Botero to Wilhelm Roscher. Protectionism, patents, economic interventionism etc are all policies needed to learn and master the production process required in manufacturing (at the time it was cotton industry, then railways and steel, and so on, high tech manufacturing in particular). In this sense, it is a matter of context and time, not really an abstract choice.

Have you ever read this?

http://www.levyinstitute.org/pubs/wp_616.pdf

There is an interesting literature that explores economic complexity issues. And they all come from early mercantilist thought, even if they are unaware of this.

LKThe issue is: is it better for a nation to shun those industries where its comparative advantage lies when they are dead-end sectors that will have diminishing returns to scale and rising costs?

Let’s analyse this issue briefly.

As you may know, assumptions about returns to scale do not say anything about costs. This concept refers to the increase in output when the inputs are increased by a given factor. This means that increasing returns to scale may well cause an increase of unit costs if the input prices increase disproportionally.

Furthermore, increasing as well as diminishing returns can occur in any sector. Up to a certain level of production, a sector may have increasing returns. Beyond this level, which nobody can predict a priori, the same sector may switch to diminishing returns.

Let's assume that all important economic sectors in a developing country start having diminishing returns. Your whole argument rests on the premise that this country cannot diversify into other sectors under a free trade regime. You seem to believe that free trade would condemn the country to a certain disadvantage pattern of trade. But what specifically hinders the country to diversify? Comparative advantage? I don’t think so.

You seem to be thinking in terms of the notion of comparative advantage propagated by the neoclassical paradigm: constant labor costs; complete specialisation, etc. As I am trying to explain in the paper, this is not the notion of comparative advantage that Ricardo had.

Of course every country needs to have industrial methods of production in order to increase its wealth. Free trade is an encouragement for the industrial development – not an impediment. Under a free trade regime, industries are set up from the beginning to produce for the world market – the largest possible scale of production. Do you really believe that industries located in developing countries are facing a cost disadvantage with respect to the developed countries? It seems to me that today Europeans and Americans are more concern of competitors located in China, India, Brazil or Mexico than the other way around.

With all due respect, your argument seem to be almost comically out of touch with the current political realities. Today many developing countries are begging the developed countries to give up protectionist barriers in agriculture and medicine (patents) which are the real obstacles to their economic development. The strongest protectionist movements do not seem to be forming in developing countries, but in the US (Trump) and Europe. Which Mexican magnate is claiming that their trading partners are ripping them off? Who voted recently against a genuine policy of free trade (not only free movement of goods, services and capital, but also labor), England or Poland?

(2) "Do you really believe that industries located in developing countries are facing a cost disadvantage with respect to the developed countries?"

Of course they can if First world countries are very efficient and have low average unit costs owing to the very large scale of production and high levels of productivity, as compared with might what may very well be high average unit costs and sunk costs of setting a new business in the Third world.

(3) "The strongest protectionist movements do not seem to be forming in developing countries, but in the US (Trump) and Europe."

Which only goes to show how ruinous this cult of free trade has been for the Western world.

(4) Finally, let us get this straight: do you think that protectionism has *never* been required by any country in any time of history to develop industry? Yes or no?

"The strongest protectionist movements do not seem to be forming in developing countries, but in the US (Trump) and Europe."

Well you forget the country which gain the most from western free trade policies is (surprise surprise) the archi protectionist china which absorbed the biggest amount of manufacturing jobs from the west as well as indonesia is another rising protectionist giant.

And of course they are not complaining about free trade since they are not having it they are having managed trade policies instead and they exploit the west by classic begger thy neighbour policies.

so this is the countries which get all this manufacturing jobs Not poor underdeveloped countries which surrendered to draconian IMF conditions which include free trade.

This countries which surrendered to IMF conditions unlike china had really small growth in manufacturing jobs and their openness to the market created dependency on import of basic food which in turn caused to mass starvation in africa also free trade policies dont really modernized their agriculture sector its still mainly labour intensive tradional economic sector in this poor countries also its created a bizzare situation where their agriculture sector is oriented on export products (instead of orienting its agriculure sector on basic products which this poor society needs).

As well its created strong dependency on export oriented agriculture products (cacao in ghana for example) or on export of natural resources while the production of this natural resources is poorly developed.

The same we can say about latin america since neoliberal free trade age began (venezuela bolivia and etc are included here since they had no managed trade and actually even not really a keynesian or post keynesian policies either).

Countries in latin america as well as in africa developing economically only during commodity boom and decline when its ends and usually its accompanied with double or triple digit inflation numbers,

not to mention the fact that since the free trade age began there is no serious industralization of latin american countries (perhaphs uruguay is an exception which imposed a policy of high tech industralization and diversification of the economy after the crisis in the early 2000-s)

(except chile which again base its economy on copper but intervene pretty intenesievely in its economy not like the myth is going).

So we should ask our questions

Its helped to boost average rate of real gdp growth? No

Its helped with trade deficits of this countries ? No its made the trade deficit even worse (just show how the theory of ricardo is wrong in a nutshell)

Increased inequality and poverty? Of course

Helped develop strong economy industralized economy? No

Helped to get manufacuring jobs from western rich countries? No

which countries impose a threat on manufacturing jobs in the west?

Countries which been forced to open to global trade in africa and latin america?

Thanks for going over this, LK - and for the reading recommendations. As I mentioned before, I've been taking a short course on Economics through a website that offers free University level online classes:

https://www.coursera.org/learn/economic-growth-part-1

One of the video lectures was on Ricardo's theory of Comparative Advantage. I posted in the discussion forums to ask for clarification, since the way it was described made little sense to me! I still haven't gotten a reply. I'm guessing this isn't a popular course with a lot of participants.

If I can get the one video downloaded, I'll post it for you so you can see what I mean.

Reinert, Chang, Bairoch, De Cecco etc, they all come from Friedrich List, the great 19th century german economist. Anyway, List wasn't really original, he comes from the American School (Hamilton, Carey, Raymond) and they come from the early mercantilism (Mun, Cary, Genovesi, Galiani etc). They all knew what free trade really meant, and they all knew that it wasn't the only game in town. Economic historians are aware that the main features of economic history (last 500 years) are protectionism, selective immigration, patents, import substitution, trade war, economic interventionism and so on. Free trade is a rather recent phenomenon.

"[...] As proof of this, the fact, that his system has been universally rejected by all the great statesmen of England, may be relied on, as almost conclusive. It will hardly be pretended, that the Pitts, the Foxes, the Pelhams, the Pulteneys, and the Walpoles of England, were not as great practical statesmen, as Adam Smith; but those men, who lived and reigned before Dr. Smith wrote, never adopted the system he recommends: and those who have lived and reigned since, have wholly rejected it. It misfit answer a very good purpose for them, to cry up his system, that other nations might be gulled by it, but they did not choose to be gulled by it themselves. (page 134, 1820)"

They all knew it was propaganda, really. Modern economists don't spent time reading history of economic thought and they seem to reject the importance of economic history. They love economic models. But as Raymond suggests, statesman don't care about economic models, the élites don't follow economists, but businessmen, merchants, bankers, that is, the élite.